Sei sulla pagina 1di 49

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter 7
International
Parity
Conditions

6-2
International Parity Conditions:
Learning Objectives
Examine how price levels and price level changes (inflation) in
countries determine the exchange rate at which their currencies
are traded
Show how interest rates reflect inflationary forces within each
country and currency
Explain how forward markets for currencies reflect
expectations held by market participants about the future spot
rate
Analyze how, in equilibrium, the spot and forward currency
markets are aligned with interest differentials
6-3
International Parity Conditions
The economic theories which link exchange
rates, price levels, and interest rates together are
called international parity conditions

These theories may not always work out to be
true when compared to what students and
practitioners observe in the real world, but they
are central to any understanding of how
multinational business is conducted
6-4
P
$
S = P


Where the price of the product in US dollars (P
$
), multiplied
by the spot exchange rate (S, yen per dollar), equals the
price of the product in Japanese yen (P

)
Prices and Exchange Rates
The Law of one price states that all else being equal (no
transaction costs) a products price should be the same
in all markets
Even if prices for a particular product are in different
currencies, the law of one price states that



6-5
P
P
S =

$
Prices and Exchange Rates
Conversely, if the prices were stated in local
currencies, and markets were efficient, the
exchange rate could be deduced from the
relative local product prices
Purchasing power parity (PPP)
(1) Absolute PPP
states that the spot exchange rate is determined by the relative
prices of similar baskets of goods. Goods and services should
cost the same regardless of the country

This simply requires replacing a single product with a price index.

Example: if the price index in USD is the price of basket of goods
in the US and a price index in AUD is the price of a similar
basket of goods in Australia, then :

Price index USD = Price index AUD ( spot USD/AUD)

Problem: difficult of getting similar basket goods for both
countries, because due to each countrys different consumption
patterns.

6-7
Purchasing Power Parity &
The Law of One Price
If the Law of One Price were true for all goods, the
purchasing power parity (PPP) exchange rate could be
found from any set of prices
Through price comparison, prices of individual
products can be determined through the PPP exchange
rate
This is the absolute theory of purchasing power parity
Absolute PPP states that the spot exchange rate is
determined by the relative prices of similar basket of
goods
The Purchasing Power Parity
(PPP)
6-8
6-9
The Hamburger Standard
The Big Mac Index, as it has been christened by The
Economist is a prime example of this law of one price :
Assuming that the Big Mac is identical in all countries, it
serves as a comparison point as to whether or not currencies
are trading at market prices
Big Mac in China costs Yuan 11.0 (local currency), while the
same Big Mac in the US costs $3,41
The actual exchange rate was Yuan 7.60/$ at the time
6-10
The Hamburger Standard
The price of a Big Mac in Chinese Yuan in U.S. dollar-terms
was therefore:



The Economist then calculates the implied purchasing power
parity rate of exchange using the actual price of the Big Mac
in China over the price of the Big Mac in U.S. dollars:

Yuan 11.0
Yuan 7.60/$
= $1.45
Yuan 11.0
$3.41
=
Yuan 3.23/$
6-11
Yuan 3.23/$ - Yuan 7.60/$
Yuan 7.60/$
= -58%
The Hamburger Standard
Now comparing the implied PPP rate of exchange,
Yuan 3.23/$, with the actual market rate of exchange
at that time, Yuan 7.60/$, the degree to which the
Chinese Yuan is either undervalued or overvalued
versus the U.S. dollar is calculated:

6-12
Exhibit 6.1 Cash and Carry:
The Hamburger Standard
6-13
Exhibit 6.1 Cash and Carry:
The Hamburger Standard (cont.)
6-14
Relative Purchasing Power Parity
If the assumptions of absolute PPP theory are relaxed,
we observe relative purchasing power parity
This idea is that PPP is not particularly helpful in
determining what the spot rate is today, but that the relative
change in prices between countries over a period of time
determines the change in exchange rates

Moreover, if the spot rate between 2 countries starts in
equilibrium, any change in the differential rate of inflation
between them tends to be offset over the long run by an equal
but opposite change in the spot rate
6-15
Exhibit 6.2 Relative Purchasing
Power Parity (PPP)
6-16
Relative Purchasing Power Parity
Empirical tests of both relative and absolute
purchasing power parity show that for the most part,
PPP tends to not be accurate in predicting future
exchange rates

Two general conclusions can be drawn from the tests:
PPP holds up well over the very long term but is poor for
short term estimates
The theory holds better for countries with relatively high
rates of inflation and underdeveloped capital markets
6-17
Exchange Rate Indices:
Real and Nominal
In order to evaluate a single currencys value against
all other currencies in terms of whether or not the
currency is over or undervalued, exchange rate
indices were created
These indices are formed by trade-weighting the bilateral
exchange rates between the home country and its trading
partners
The nominal exchange rate index uses actual
exchange rates to create an index on a weighted average
basis of the value of the subject currency over a period
of time
6-18
FC
$
$
N
$
R
C
C
x E E =
Exchange Rate Indices:
Real and Nominal
The real effective exchange rate index indicates how
the weighted average purchasing power of the currency
has changed relative to some arbitrarily selected base
period
Example: The real effective rate for the US dollar (E
$
) is
found by multiplying the nominal rate index (E
$
) by the ratio
of US dollar costs (C$) over foreign currency costs (CFC)
R
N
6-19
Exhibit 6.3 IMFs Real Effective Exchange
Rate Indexes for the United States, Japan, and
the Euro Area (2000 =100)
6-20
Exchange Rate Indices:
Real and Nominal
If changes in exchange rates just offset differential
inflation rates if purchasing power parity holds
all the real effective exchange rate indices would
stay at 100

If a rate strengthened (overvalued) or weakened
(undervalue) then the index value would be 100
6-21
S x P P
BMW
$
BMW
=
/$
Exchange Rate Pass-Through
Incomplete exchange rate pass-through is one reason that
countrys real effective exchange rate index can deviate from
its PPP equilibrium point
The degree to which the prices of imported & exported goods change as
a result of exchange rate changes is termed pass-through

Example: assume BMW produces a car in Germany and all costs are
incurred in euros. When the car is exported to the US, the price of the
BMW should be the euro value converted to dollars at the spot rate

Where P$ is the BMW price in dollars, P is the BMW price in euros
and S is the spot rate
6-22
14.29% or , 1429 . 1
000 , 35 $
000 , 40 $

P
P
$
1 BMW,
$
2 BMW,
+ = =
The degree of pass-through in this case is partial, 14.29% 20.00% or approximately
0.71. Only 71.0% of the change has been passed through to the US dollar price
Exchange Rate Pass-Through
Incomplete exchange rate pass-through is one reason that a countrys real effective
exchange rate index can deviate for lengthy periods from its PPP-equilibrium level
If the euro appreciated 20% against the dollar, but the price of the BMW in the US
market rose to only $40,000, and not $42,000 as is the case under complete pass-
through, the pass-through is partial
The degree of pass-through is measured by the proportion of the exchange rate
change reflected in dollar prices
6-23
Exhibit 6.4
Exchange Rate Pass-Through
6-24
i = r + t + r t
Where i is the nominal rate, r is the real rate of interest, and t is
the expected rate of inflation over the period of time
The cross-product term, r t, is usually dropped due to its
relatively minor value
Interest Rates and Exchange Rates
Prices between countries are related by exchange rates and now
we discuss how exchange rates are linked to interest rates
The Fisher Effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation. As a formula, The Fisher
Effect is




nominal interest rates in each country are equal to the required real rate of return
(r) plus compensation for expected inflation (t)

6-25
i = r + t ; i = r + t
$ $ $
It should be noted that this requires a forecast of the future rate of
inflation, not what inflation has been, and predicting the future can be
difficult!
Interest Rates and Exchange Rates
Applied to two different countries, like the
US and Japan, the Fisher Effect would be stated
as




International Fisher effect
the spot exchange rate should change in an amount equal to but in the opposite
direction of the difference in interest rates between countries

6-26
i i 100 x
S
S S
$
2
2 1
=


Interest Rates and Exchange Rates
The international Fisher effect, or Fisher-open, states
that the spot exchange rate should change in an amount
equal to but in the opposite direction of the difference
in interest rates between countries
if we were to use the US dollar and the Japanese yen, the
expected change in the spot exchange rate between the dollar
and yen should be (in approximate form)
6-27
Interest Rates and Exchange Rates
Justification for the international Fisher effect
is that investors must be rewarded or penalized
to offset the expected change in exchange rates

The international Fisher effect predicts that with
unrestricted capital flows, an investor should be
indifferent between investing in dollar or yen
bonds, since investors worldwide would see the
same opportunity and compete it away
6-28
Interest Rates and Exchange Rates
The Forward Rate
A forward rate is an exchange rate quoted today for
settlement at some future date

The forward exchange agreement between currencies states
the rate of exchange at which a foreign currency will be
bought or sold forward at a specific date in the future
(typically 30, 60, 90, 180, 270 or 360 days)

The forward rate is calculated by adjusting the current spot
rate by the ratio of euro currency interest rates of the same
maturity for the two subject currencies
6-29
(

|
.
|

\
|
+
(

|
.
|

\
|
+
=
360
90
x i 1
360
90
x i 1
x S F
$
FC
FC/$ FC/$
90
Interest Rates and Exchange Rates
The Forward Rate
6-30
$ Sfr1.4655/
1.02
1.01
x Sfr1.4800
360
90
x 0.800 1
360
90
x 0.400 1
x Sfr1.4800
Sfr/$
90
F = =
+
+
=
(

|
.
|

\
|
(

|
.
|

\
|
Interest Rates and Exchange Rates
The Forward Rate example with spot rate of
Sfr1.4800/$, a 90-day euro Swiss franc deposit
rate of 4.00% p.a. and a 90-day euro-dollar
deposit rate of 8.00% p.a.
6-31
100 x
days
360
x
Forward
Forward - Spot
f
FC
=
For direct quotes ($/FC), then F-S/S should be applied
Interest Rates and Exchange Rates
The forward premium or discount is the percentage
difference between the spot and forward rates stated in
annual percentage terms
When stated in indirect terms (foreign currency per home
currency units, FC/$) then formula is
6-32
Exhibit 6.5 Currency Yield Curves
and the Forward Premium
6-33
p.a. 3.96% 100 x
90
360
x
Sfr1.4655
Sfr1.4655 - Sfr1.4800
f
Sfr
+ = =
100 x
days
360
x
Foward
Foward - Spot
f
FC
=
The positive sign indicates that the Swiss franc is selling
forward at a premium of 3.96% per annum (it takes 3.96% more
dollars to get a franc at the 90-day forward rate)
Interest Rates and Exchange Rates
Using the previous Sfr example, the forward
discount or premium would be as follows:
6-34
Interest Rate Parity (IRP)
I nterest rate parity theory provides the linkage between foreign
exchange markets and international money markets
The theory states that the difference in the national interest
rates for securities of similar risk and maturity should be equal
to, but opposite sign to, the forward rate discount or premium
for the foreign currency, except for transaction costs

The arbitrage condition called the I nterest Rate Parity (I RP) condition or
Covered I nterest Parity (CIP) condition states that the prices from risk-free
assets with identical maturity should be equated across countries, after
translation in a common currency.
6-35
Interest Rate Parity (IRP)
In the diagram in the following slide, a US
dollar-based investor with $1 million to invest, is
shown indifferent between dollar-denominated
securities for 90 days earning 8.00% per annum,
or Swiss franc-denominated securities of similar
risk and maturity earning 4.00% per annum,
when cover against currency risk is obtained
with a forward contract
What is arbitrage ?

Business operation involving the purchase of foreign exchange gold,
financial securities or commodities in one market and their almost
simultaneous sale in another market, in order to profit from price
differentials existing between the markets.

Arbitrage generally tends to eliminate price differentials between
markets.

So,
the act of simultaneously buying and selling the same or equivalent
assets or commodities for the purpose of making certain profit.

6-37
Exhibit 6.6 Interest Rate Parity
(IRP)
6-38
Covered Interest Arbitrage (CIA)
Spot & Forward exchange markets are not in equilibrium
Covered interest arbitrage is an arbitrage trading strategy
whereby an investor capitalizes on the interest rate differential
between two countries by using a forward contract to cover
(eliminate exposure to) exchange rate risk

Because the spot and forward markets are not always in a state of
equilibrium as described by IRP, the opportunity for arbitrage
exists
The arbitrageur who recognizes this imbalance can invest in the
currency that offers the higher return on a covered basis

This is known as covered interest arbitrage (CI A)

6-39
Exhibit 6.7 Covered Interest
Arbitrage (CIA)
6-40
Covered Interest Arbitrage (CIA)
A deviation from CI A is uncovered interest arbitrage,
UI A, wherein investors borrow in currencies exhibiting
relatively low interest rates and convert the proceeds
into currencies which offer higher interest rates

The transaction is uncovered because the investor
does not sell the currency forward, thus remaining
uncovered to any risk of the currency deviating
6-41
Covered Interest Arbitrage (CIA)
Rule of Thumb:
If the difference in interest rates is greater than the
forward premium (or expected change in the spot
rate), invest in the higher yielding currency.

If the difference in interest rates is less than the
forward premium (or expected change in the spot
rate), invest in the lower yielding currency.
6-42
Exhibit 6.8 Uncovered Interest
Arbitrage (UIA): The Yen Carry Trade
6-43
Exhibit 6.9 Interest Rate Parity
(IRP) and Equilibrium
6-44
Forward Rates as an
Unbiased Predictor
If the foreign exchange markets are thought to be
efficient then the forward rate should be an unbiased
predictor of the future spot rate

This is roughly equivalent to saying that the forward
rate can act as a prediction of the future spot exchange
rate, and it will often miss the actual future spot rate,
but it will miss with equal probabilities (directions) and
magnitudes (distances)
6-45
Exhibit 6.10 Forward Rate as an
Unbiased Predictor for Future Spot Rate
6-46
Prices, Interest Rates and
Exchange Rates in Equilibrium
(A) Purchasing power parity
forecasts the change in the spot rate on the basis of differences in expected rates of
inflation
(B) Fisher effect
nominal interest rates in each country are equal to the required real rate of return
(r) plus compensation for expected inflation (t)
(C) International Fisher effect
the spot exchange rate should change in an amount equal to but in the opposite
direction of the difference in interest rates between countries
(D) Interest rate parity
the difference in the national interest rates should be equal to, but opposite in sign
to, the forward rate discount or premium for the foreign currency, except for
transaction costs
(E) Forward rate as an unbiased predictor
the forward rate is an efficient predictor of the future spot rate, assuming that the
foreign exchange market is reasonably efficient
6-47
Exhibit 6.11
International Parity Conditions in
Equilibrium (Approximate Form)
6-48
Summary of Learning Objectives
Parity conditions have traditionally been used by economists to
help explain the long run trend in an exchange rate
Under conditions of free floating rates, the expected rate of change
in the spot rate, differential interest and inflation rates, and the
forward rate are all directional and proportional to each other
If two products are identical across borders and there are no
transaction costs, the products price should be the same in both
countries. This is the law of one price
The absolute theory of PPP states that the spot rate is determined
by the relative prices of similar goods
The relative theory of PPP states that if the spot rate starts in
equilibrium, any change in the differential inflation rates should
be offset over the long run by an opposite change in the spot rate
6-49
Summary of Learning Objectives
The Fisher Effect states that nominal interest rates in each country
are equal to the required real rate of return plus compensation for
expected inflation
The international Fisher effect (Fisher open states that the spot
rate should change in an equal amount but in the opposite
direction to the difference in interest rates between two countries
The IRP theory states that the difference between national interest
rates for similar securities should be equal to, but opposite sign to,
the forward discount or premium rate excluding transaction costs
When the forward and spot market rates are not in equilibrium, the
opportunity for risk free arbitrage exists. This is termed covered
interest arbitrage
If markets are believed to be efficient, then the forward rate is
considered an unbiased predictor of the future spot rate

Potrebbero piacerti anche